Finance for Engineers: Financial Ratios

A handful of ratios can provide quick visibility into any business; financial ratios are early warning indicators.

Activity ratio
Activity ratios measure how effectively resources are being used. The question is whether you generate a good return on business activities. And no, this isn't return on investment. Let's look at the average collection period ratio. Paul's annual sales are $1,460,000, or $4,000 per day. His receivables are listed on his balance sheet as $160,000. His contracts require payment within 15 days.

Paul's customers are taking 2-3 times longer to pay than stipulated in his contracts; he needs to accelerate collections. Alternatively, he could change how he does business -- maybe collect deposits or retainers to reduce his average collection period. There is too large a gap between activity completion and payment.

Profitability ratio
Profitability ratios measure return on sales and investments. This is often the first ratio that investors consider. Are you making the profits and margin that you promised? Paul sells $1,460,000 per year. His net profit after taxes is $80,000.

Paul is underperforming his target profit margin by more than 5%. This could be due to one-time startup costs, pricing, or something else entirely. The missed target certainly requires a closer look.

When confronted by disappointing results, the first step is to go beyond the simplistic financial ratios to understand what is causing the problem. To improve profitability quickly, most businesses will try several common tactics:

Think about other ways to do things

Eliminate some things

Do less of some things

Combine some things

Do things in a different way

A word of caution
Though a ratio can illuminate one area of your business, ratios are taken at a single point in time. What matters most is the trend of your ratios. Are they moving in the right direction over time? How much does seasonality matter in your business? What would be more informative -- a month-over-month look or a year-over-year look? It is important to compare data from similar sources and draw valid conclusions based on real data.

Most ratios involve only a few numbers. Many use division of simple numbers. Graphics can help you understand the information. Engineers, especially those with experience in process control charts, are well equipped to present data in useful ways. Statistical process control (SPC) charts are a good way to communicate, but many professionals without SPC training will be more comfortable with pie charts, bar charts, trend lines, and other representations. By observing trends over time, you can use them to make better, more informed business decisions.

Most businesses are about making maximum profits for shareholders. Read your company's annual statement. This one document will allow you, as a practicing engineer, to know your business and can help you glean some very useful insights. The more you know about financial ratios and which ones are the most important for your company to report, the better you can anticipate management decisions that may affect you and your colleagues.

something about the fact that the value of a monetery unit is in flux really bothers me. A dollar doesn't have the same value at the end of an equation as it did at the beginning (just standard fluctuation), whereas a volt doesn't change!

@Max The Magnificent there is a certain logic to accounting. BUT, there are a LOT of nonsensical rules that are imposed by the way we collectively make politically-driven laws. Once I held some new product investment purse strings for a large multinational semiconductor company. At the time, there was a Financial Accounting Standards Board (FASB pronounced faz-bee). There was an accounting rule under FASB 86 that said that we were to expense our investment until we had proof that the new technology would work. Then we were mandated to capitalize the investment. How do you draw the line for a new semiconductor process, or a never-before-implemented circuit? This is just one of the reasons why many companies just can't seem to complete their tax filings as you and I must every year.

@Caleb Kraft It's funny because there are "natural constants" that we use in engineering that are actually only local constants to our particular region of the universe. But, the semiconductor industry has from time-to-time invented new ways to adjust the price of a component. Take the infamous "gold adder" from the late 1970s. Many of our packages used a relatively large amount of gold which could cause fluctuations in the raw materials cost to produce a package component. So, we instituted a gold adder which was initially tied to the price of gold. Funny thing is that when the price of gold stabilized and new pricing came out, many companies kept the gold adder and used it as an excuse for "high component prices."

Of course, this was the same time when it was financially advantageous to borrow money to buy "things" because the net cost of borrowing was lower than the inflation rate of your salary (which was going up to keep pace with inflation). Managing projects during this time was difficult because the average stay with one employer was significantly less than the time to complete the project.

@Henry: ...but just fail to file and you'll find out what strange can be...

Actually I'm a bit of an anal retentive re Taxes ... it's like the fact that I always drive at the speed limit so I never worry when I see a police car hiding at the side of the road -- there's a filing cabinet just outside my office that holds all my tax records and receipts and stuff since I moved here in 1990 -- plus my accountant has copies -- I'm so squeeky clean it's embarrasing LOL

In my version of reality, management/finance and engineering are two different worlds. Being in the engineering side, my impression is that management can't seem to grasp reality, all too often.

The recurring example is related to obsessing over just those ratios.

If there's a job to be done, which usually entails something not quite trivial, and something that needs to be completed in a timely manner, engineering has to get going on it. Management likes to stall the effort until they have their dollars all lined up, which makes sense from their perspective as far as that goes. But then, when they finally give the go-ahead to engineering, they expect engineering to rush the work through by some ridiculous deadline. There has to be a better way. There has to be a way of making funds available early, so the work can be done correctly, getting people to work on it as soon as their schedule permits.

I've been at this for decades. It's no surprise at all to me that so many programs seem sluggish and ponderous. Engineering has to find ways to sidestep management, or programs end up being just that. Sluggish, ponderous, unresponsive.

@Max The Magnificent Squeeky clean huh? I'd say that you demonstarte a fine sense of what battles are a loosing proposition from the start. I know one fellow who is a multi-millionair several toems over. He's been in na never-ending series of tax disputes for more than 15 years. He's spent MORE on his legal cases than he would have spent had he simply paid ...

In the yUK, TAX rules amount to over 11500 pages, VAT more than 800, the all that EU rules stuff. Not checked to see if it's less or more now (10 years but greater is a distinct probability), no interest in that BS whatsoever!

Cash flow is King to any company. I was never motivated in accounts any less than 3 to 6 months apart. Guess what happens?

Maths, physics, chemistry and electronics. GOOD fun stuff.

A day job and others doing the S&M and beans would be great right now!